Sunday, 24 February 2008

Welcome to the weekly report. The turmoil in credit markets continues and attention moves to CDS, the Federal Reserve gets worried about its credibility and the US markets get a boost 15 minutes from the end of Fridays close. We finish with a quick recap of some stocks we looked at last week and look around to see if anything else catches our eye.

Firstly an update to the continuing and widening collapse of the Municipal Bond prices as the failures in the auction rate bond (ARB) markets grow. Last week I mentioned 3 market makers who had stopped supporting ARB with their own capital to support prices. That list has grown, in addition to Citi, Goldman Sachs and Lehman Bros you can now add UBS, Morgan Stanley and Merrill Lynch. Without wanting to labour the point that's 6 of the biggest Investment Brokers / Banks that are effectively saying either the Muni bond market is toxic or they do not have the capital to support the Muni market. I firmly believe it is the latter.

I want to show you one chart that supports my assertion. It's from the Fed:

Colin Twiggs of Incredible Charts produced the chart, which saved me having to do it. You have seen this chart in my previously written articles. Clearly the situation has deteriorated at a rapid pace and is much more serious than the credit scare last August. US banks have no reserves; they are for all intents and purposes, broke. In fact they are beyond broke and as I suggested last year banks are now sub-prime. 150% of the reserves at depository institutions are borrowed. That can only mean one thing, the banks have "lost" 1.5 times their original non borrowed reserves. Not only have they lost what they had, they went on and lost half as much again. If you or I did that, we would be bankrupted and probably arrested for attempting to defraud the lender.

Notice the amount of total reserves (yellow line) is roughly equal and appears cyclical to the Federal Reserve TAF lending programme. The Fed is no longer the "lender of last resort" it has become the de-facto Bank of the USA.

I am amazed that so little attention has been paid to this state of affairs. The Northern Rock debacle, one overstretched bank in the UK, has had all the headlines, yet with the WHOLE banking industry in the US insolvent you hardly see it mentioned.

Now, I am not going to give you advice on what to do about your cash on deposit and I don't want you to think I am being overly bearish but…….I have called this whole fiat credit collapse correctly from the beginning. No, I don't want a pat on the back. I just want to read the next line carefully.

If I had money in a US bank today, I would be worried. So worried I would withdraw the cash before new regulations are passed restricting account activity. I know it sounds alarmist but then the first warnings always do.

This week saw talk of problems becoming apparent in the Credit Default Swap markets, a leveraged, counterparty insurance and re-insurance scheme designed to protect a buyer of debt against a default event using a third party who sells the protection.

For some of us, this is old news and signs of trouble have been around for sometime. Spreads on corporate debt have widened significantly of late. The Markit iTraxx Europe Index (yes Europe, you didn't think it was just the USA having problems did you?) composed of the prices of CDS for 125 investment graded companies saw spreads widen to 135 basis points, up from 91bp just 2 weeks ago. The higher the spread, the more perceived risk is seen in the markets. Get this, investors in this market are getting compensated for possible default rates up to 5.5 times higher than the highest recorded levels in the past 50 years.

Maybe I'm wrong to point out rising risk, maybe it's just over reaction and the spreads will fall back. Then again it is the market telling you about risk, not me.

The Federal Reserve seems to have a problem. It is becoming clear that even members of the committee are worried about the direction of Fed policy. The concern seems to be rooted in very economic soul of the committee members. Those that believe interest rates should go no lower or, indeed rise, are becoming more vocal. The latest to speak out was Dallas Fed President Richard Fisher. Although he has attracted a reputation for speaking "off message" thanks to the 8th innings remarks about interest rate rises, he has since then been a very clear and concise speaker. After voting against the latest cut in FFR (9-1) he has been explaining why he is worried.

Mr Fisher is no career economist, he is not from the Bernanke school. It may well explain why he feels strongly about the current situation. From the Dallas Morning News here is a quick run through his roots:

"Even more intriguing than Mr. Fisher's lonely vote at the Fed is the path this globe-trotter, self-made man and failed politician took to get there.After his birth in Los Angeles to a father who had emigrated from Australia and a Norwegian mother who grew up in South Africa, Mr. Fisher moved with his parents to Mexico City, where he grew up speaking Spanish at school and playing on a youth baseball team coached by Norman Borlaug, the future Nobel Peace Prize winner.

Soon afterward, the family fell on hard times and moved back to the U.S., to Miami. Mr. Fisher, then about 11, remembers going with his mother to a pawn shop there, where she sold her engagement ring for cash to buy clothes for her children.

In another shift in fate, the boy won a scholarship to a private military academy.

Years later, after studying at England's Oxford University and collecting a degree from Harvard, as well as a Stanford University MBA, he would become a wealthy fund manager - moving between the financial world and government service in a career distinguished by intellectual curiosity and an independent streak."

I fully suspect Mr Fisher does not rely on computer models of the economy to get his "feel" for how things are going, unlike the Fed committee chairman. This guy has been there and done it, successfully too, unlike Greenspan.

Mr Fisher understands poverty, he lived it. He knows the effects it has and the struggles it causes. He is genuinely afraid of price inflation devaluing the money in peoples' pockets. Another snippet from the Dallas Morning News tells us all we need to know about Mr Fisher:

"There's a photo of Mr. Fisher with current Fed Chairman Ben Bernanke, and a portrait of former Fed Chairman Paul Volcker, one of Mr. Fisher's heroes."

Mr Fisher understands a simple rule, if you lower interest rates you ignite $ devaluation. Do this during a period of commodity bullishness and the basics become more expensive. It also raises what the Fed calls inflation expectations. Simply put that means if people perceive that prices are going to rise, they demand more money for their labour. True monetary inflation then follows. (NB, this is mainstream thinking, not mine - I see a different outcome.)

I suspect what is really worrying Mr Fisher is that despite repeated large cuts in the FFR, real interest rates for consumers, especially those hurting right now, have not fallen. Indeed the rates at Freddie and Fannie, for instance, have been rising of late. Why administer a medicine that has no effect on the illness?

His latest remarks in a speech at Fort Worth seem to be alluding to such:

'We're trying to bridge the gap, between what most people believe will be two quarters of 'anemia' in the economy, and prevent that turning into a recession, but not at the same time 'stir those dreadful embers of inflation.'

He went on to mention that the fallout from the credit markets cannot happen without some pain and that pain cannot be removed by the Federal Reserve.

With Bernanke talking of a "consensus committee" my bet is that although only Fisher voted against a cut at the last meeting, many of the committee share his reservations on current Fed policy. As the last Fed minutes pointed out:

"When prospects for growth had improved, a reversal of a portion of the recent (rate)-easing actions, possibly even a rapid reversal, might be appropriate,"

That should be taken as a warning by anyone intending to borrow at current low rates. You do not want to be on the wrong side of a 1% rise in FFR.

A funny thing happened on the way to the market close on Friday. The markets took off with about 40 minutes of the session left, tagging on around 250 points.

The reason touted around appears to be this announcement:

"US BONDS/INSURANCE: CNBC is cited saying a bailout at bond insurer AMBAC may be reported Mon. or Tues; this news is aiding stocks."

I saw this happen, I was trading at the time and had closed out a long (I don't hold Index trades over weekends). The sell side of the Dow futures went away on holiday, resulting in trades on the buy side leap-frogging higher. A shame I didn't hang on a little longer but that's trading. It looks to me as though the market believes, or wants to believe the bail-out is good news. I have a couple of worries on that score.

Firstly, since when are bail-outs "good" news?

Secondly, another announcement on Friday hasn't been picked up on and it's much more important:

Channel Re was created in 2004 to provide "reinsurance" to MBIA, a bond insurer based in Armonk, N.Y. MBIA is Channel's only customer.

MBIA writes insurance policies that promise to repay bondholders when bond issuers default. MBIA, which insures $670 billion in debt, buys reinsurance for a little more than $70 billion of the bonds it insures.

Reinsurance essentially means buying an insurance policy to protect an insurance policy, or shifting some of the risk and some of the premiums to another insurer. Channel Re reinsures just under half of MBIA's ceded debt, implying the company guarantees more than $35 billion in bonds.

Moody's said Channel Re has "significant exposure" to risky mortgage investments. The company was too willing to accept risks from MBIA, Moody's said. Collateralized-debt obligations, or pools of different kinds of debt often layered with risky mortgage loans, constitute 12 percent of Channel's insured debt, Moody's said.

Moody's estimates Channel Re needs $1.3 billion in cash available to pay claims to maintain the top-notch rating. The company has access to $930 million, Moody's said.

When an insurer is downgraded, much of the debt the company insured is downgraded too because a bulwark protecting the debt from default is less sturdy. A downgrade of one of MBIA's reinsurers could leave MBIA itself more vulnerable to a downgrade.

Yes, notice that last line. MBIA is now suffering from the same threat of possible default on its insurance as the rest of the market is suffering from the possible default of MBIA but MBIA part owns the re-insurer! Oh the deliciousness of it all.

Short term the markets may well have gone up on the Ambac rumour. In the longer term disclosures like that from Moody's will kill it.

As I suspected Barclays pleased the markets and broke out of the wedge. I am watching for a retest of the upper wedge line and a possible attempt to take out the January high.

HBOS continues to drift sideways within its wedge as does HSBC within its down channel.

Lloy Daily.

As I said in the original article, I was surprised LLoyds didn't look more bullish. It looks bullish now.

RBS Daily:

Possibly a rise on general sentiment, I did get the feeling last week that the market believed RBS rather than the analyst talk of raising new funds etc. It appears poised for a breakout but be warned it could just as easily reverse. Worth watching as results are announced this week.

FTSE Daily

As mentioned last week 6002 is resistance with 5861 as support. I have removed the upper triangle line, leaving the rising support line. I am watching for a move either through the mentioned resistance or support.

One last point, keep an eye on UBS. The FT reports that HSH Nordbank, a German bank that is the worlds biggest provider of shipping finance, has filed lawsuit on UBS claiming it was mis-sold CDO's to the tune of E500m - apparently "lost" in an SIV called North Street 4. If this suit gets legs many other Investment Bank CEOs might start sweating too.

Have a good week.

Edit:

In answer to Richards point, I found this chart (click on image for larger size):

What me, worry?

You can clearly see the current situation dwarfs even the near past events. 1987 and 2001 look like blips. As for the 30's - well I have always said that the impending credit collapse and its deflation will make that decade look "sweet" in comparison.

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The Collection Agency

4 comments:

The chart on bank borrowed reserves is a major warning sign of severe problems that are coming very soon - in a timeframe measured in days or weeks (at best several months), but before the November election. It would be very interesting to cross-reference this chart to the data for banks during the period between October 29, 1929 (the stock market crash) and March 10th 1933 (the begining of the Roosevelt bank holiday). My gut feeling is that the data for February 2008 is substantially worse than for February 1933 (the month before the bank holiday). The other major difference between 1933 and today is that in 1933, the Federal Reserve member banks were in comparatively better possitions and most of the problems were in the non-Fed member banks. This time, the Fed member banks are effectively insolvent.

We are dangerously close to a bank holiday 75 years after the 1933 one. In 1933, banks were classified in three groups. Group A consisted of the solvent banks that could quickly reopen. Group Bconsisted of banks that were in trouble (possibly insolvent) that had some hope of achieving a workout or turn around. Group C were insolvent banks that that would be permanantly closed, their assets liquidated, and any remaining assets after liabilities were paid off would be paid to depositors. The strongest A group Fed member banks reopened four days after the bank holiday was declared. After 300 days, ~5,000 banks had reopened but >4,000 remained closed. Note that there was no holiday for debt and tax payments and that cash was in severely short supply, particularly during the first weeks of the bank holiday.

Today, virtually every major bank, including all of the money center banks are insolvent and would be classified in Group C. The FDIC is totally unprepared and does not have the reserves to pay depositors if ONE of these banks fails, let alone multiple ones.

1. The spike is to $45b, which whilst material is still a small fraction of GDP / the banking system etc. I agree though that the trend is very alarming.

2. The figures are in nominal terms, as far as I can tell from the Fed website. I suspect that the spike around WW1 may be more material in real terms or as a % of GDP than the present problem.

3. The Log of the data tells a very different story. The spike is still there, there's a valley around the depression and WW2 but post war it has been a roughly constant log.

My personal view is that the current series of unfortunate events are a combination of a classic banking crisis coupled with a reinsurance spiral.

Tell me have you thought about your role in what is occuring? If you think a theatre isn't fire safe it seems fair to question it, but when we are all in the theatre and can smell the smoke aren't you just going to cause a stampede?

I have been hanging around the foyer, trying to persuade people not to enter the auditorium. The "fire" has already started and casualties are assured.

The amount shown in the added chart seems small. Then again so does the amount used by the Fed for the TAF programme. This is the seed money, the amount required to bring reserves up to the levels needed to allow the continued existence of fractional lending. It's the same as getting a margin call and deciding to keep the position open.

Most of the huge multi-billion losses we have seen are the result of deleveraging, the withdrawal of credit. The numbers exist on ledgers, in computerised accounts, not as cash. A keystroke wipes out 90% of the amount, the other 10% is the capital used (borrowed) to leverage the deal.

As any trader/investor knows, using margin has it's downside. When losses demand the addition of more funds, some add and some fold.

It seems the banks have decided to keep borrowing, adding to margin, even though the original capital and half as much again, has been lost.

Hello and welcome.
Don't worry about the title, its my username on financial bulletin boards. I have no interest in your home or car.
Unless its a very fast car.
I have been trading for nearly 10 years and writing my thoughts on the longer term, macro-economic view for most of that time. Recently I decided to formalise my writing, moving from Bulletin Boards and producing occasional letters (as some people enjoyed reading my jottings).